Income Tax Withholding on Certain Periodic Retirement and Annuity Payments Under Section 3405(a), 26 CFR Parts 31 and 35, 85 Fed. Reg. 61813 (Oct. 1, 2020)
The IRS has updated its regulation on income tax withholding from periodic payments to reflect changes made by the Tax Cuts and Jobs Act (TCJA) (see our Checkpoint article). Prior to the TCJA, a temporary regulation specified that the default rate of withholding on periodic retirement and annuity payments had to be determined by treating the recipient as married and claiming three withholding allowances. The TCJA, however, eliminated the concept of withholding allowances, rendering the temporary regulation obsolete. The IRS then issued guidance preserving the use of withholding allowances to determine withholding on periodic payments (see our Checkpoint article). But this approach has become more problematic for plans and recipients of periodic payments, as the redesigned Form W-4 (Employee’s Withholding Certificate) no longer uses withholding allowances to determine the amount withheld.
The final regulation—which is identical to the proposed version—removes the temporary regulation and sets basic ground rules for withholding on periodic payments without establishing a new default withholding rate. The regulation first clarifies that it applies only to periodic payments that are not eligible rollover distributions, and indicates where to find other rules, such as the additional rules applicable to distributions delivered outside the United States. The regulation then restates the statutory general rule that periodic payments that are not eligible rollover distributions are subject to withholding as if they were payments of wages for the appropriate payroll period. For distributions to recipients who fail to supply a withholding certificate on Form W-4P (Withholding Certificate for Pension or Annuity Payments), income tax must be withheld in accordance with “the applicable forms, instructions, publications, and other guidance prescribed by the [IRS].” Those default rules will apply even if the employer knows the recipient’s marital or tax filing status (e.g., for purposes of wage withholding). Finally, the regulation indicates that the rules applicable to withholding certificates for periodic payments will “parallel” the rules for wage withholding unless the Code’s rules for periodic payments specifically provide otherwise. The regulation applies to periodic payments made after December 31, 2020.
EBIA Comment: By eliminating the temporary regulation that tied default withholding rates to the old system of withholding allowances, the IRS has freed itself to consider alternatives. For example, one possibility—raised in both of the written comments on the proposed regulations—would be to use a 10% flat rate. But whether the IRS will warm to a flat rate or take a different approach remains to be seen. For more information, see EBIA’s 401(k) Plans manual at Sections XIV.B (“Defining an Eligible Rollover Distribution”) and XIV.J.2 (“Income Tax and Withholding Rules for Plan Distributions Other Than Eligible Rollover Distributions”).
Contributing Editors: EBIA Staff.